Europes American dream
Many hope that the introduction of a single currency will lead to a dramatic improvement in European financial markets. But, as our fifth euro brief argues, change in Europe may come more slowly than some expect
COMPARED with those of the United States, the bond and equity markets of the 11 countries about to join the euro are of modest means. The companies of continental Europe still rely disproportionately on banks for finance. The arrival of the euro offers a chance to change that, creating a single, liquid capital market that might eventually rival Americas.
Europe desperately needs such a change. Its population is ageing and its pay-as-you-go pension systems are woefully underfunded. At present, Europes fragmented capital markets do not ensure ageing Europeans the best return on their savings; and Europes companies treat their shareholders withat bestcasual disdain.
Undoubtedly the euro-denominated government-bond market will be big. Outstanding bonds issued by the 11 euro countries amount to 1.8 trillion ecusas it happens, exactly the same size as the American treasury-bond market. The bigger question is what impact the euro will have on corporate finance.
At present, some three-quarters of continental European companies finance comes from banks and other sorts of lender and only a quarter from the capital markets. In the Netherlands, half of companies finance comes from banks; in France, Italy and Germany, 70%, and in Spain 80%. In America, in contrast, only a quarter of companies financing needs comes from banks.
Moreover, these figures disguise the extent to which European companies are wedded to banks. Most bonds issued in the EU are from companies with top-notch credit ratings (AA and above); in America the proportion is 30%. Riskier credits are largely excluded from the capital markets. The corporate-bond market for those in EMU is, in total, half the size of Americas. But some four-fifths of European corporate borrowing is by financial institutions.
Even so, stock exchanges are gearing up. At the beginning of 1999, the London Stock Exchange is to link with Deutsche Börse to develop a stockmarket for 300 of Europes biggest companies (see article). Other stock exchanges are also to join, creating a single market in European equities.
Deeper capital markets should make financing more flexible and cheaper. With luck, a change in ownership structures might have a yet more important effect: it might persuade European companies to take shareholders more seriously. That, in turn, would improve returns and productivity. There is, in short, a lot riding on the effect of the euro on the capital markets.
The European Commission has made some progress in unifying Europes capital markets. Banks can, in theory, operate throughout the EU. Capital requirements for banks and securities firms have been standardised. Stock exchanges can plonk their trading terminals in any EU country. Fund-management firms can sell their wares throughout the region.
A single passport, issued by any one of the member countries, allows a financial firm to operate anywhere in the EU as long as it is registered in one of the countries. This is backed up by a system of consolidated supervision in which the regulator in the country in which a firm is based has primary responsibility for regulating it.
But progress has been slow. There have been significant accumulated delays in implementing agreed rules, said a recent commission report. Within EU countries, there are wide variations: in disclosure requirements for companies wanting to issue securities; in trading rules, such as how much financial firms must reveal about the trades they do; in accounting standards; and in tax treatment, for example of life-insurance and pension products, or of interest received (Germany, for example, levies a 25% withholding tax; Italy, only 12.5%).
Aggravating this fragmentation are laws forcing European life insurers to match 80% of their assets with liabilities in the same currencies; in general, pension funds have similar, though less draconian, restrictions.
So it is clear that at present Europe does not have a unified capital market. Will the introduction of the euro speed up the process?
The first step will come on January 1st. Currency union among the 11 participating countries will remove currency risk between their financial markets. An Italian investor thinking of investing in German government bonds, say, will no longer have to worry about how the lira will fare against the D-mark.
But the market will not be as homogeneous as that for American treasuries. Credit differences between countries will remain: in theory, at least, the European Central Bank is not allowed to bail out those countries that get into trouble. Countries charge different rates of withholding tax on bonds, although the European Commission wants to harmonise that taxs treatment. Markets also differ in the way in which government bonds are issued and traded. France has regular auctions of bonds with differing maturities; Germany does not. These differences will be ironed out only gradually.
Even if Europes government-bond market is not completely unified, will other capital markets blossom? Quite possibly: Europes low and declining inflation will drive down yields on government bondsperhaps to an average of 3.75% next year for the 11 countries, reckons Goldman Sachs. That will encourage Europes ageing savers to look for other things to invest in.
At present, some 90% of domestic savings are invested at home, often with dismal returns. And the amount of money that needs to be invested is growing fast. In 1996, there were $630 billion of pension assets in Europe; by 2001, reckons the Bank of England, there will be $1,800 billion. For insurance companies the figures are $2,600 billion and $6,300 billion.
Currency union will allow investors to spread their wings. Small markets will no longer be fragmented by currency. Investors in, say, Belgium, will find it easier to buy German bonds or Italian shares. Once both assets and liabilities are denominated in euros, the restrictions on where pension funds and life insurance companies can put their cash will become redundant.
portfolios, which are now mostly invested in bonds, will start to resemble British or American portfolios, which are mostly invested in equities.
Banking on borrowers
So much for demand. The supply of both corporate bonds and equities also seems set to increase. In the case of corporate bonds, supply depends upon the extent to which companies turn from bank borrowing to capital markets. The reason that most companies have not tapped capital markets in the past is clear: banks lend more cheaply. That will now change, as the banks find it harder to cut marginsbut change will be slow.
A fall in the costs of borrowing in the bond markets will eventually occur simply because the demand for high-yielding corporate bonds will rise. That will persuade companies to go to the markets rather than to banks. Goldman Sachs guesses that Europes corporate-bond market could grow fivefold.
By when? The answer depends on how vigorously Europes banks fight back in their lending business. Banks have generally undercut capital markets because they think that they get other business from companies to which they lend. Moreover, they have captive depositors, who have been understandably reluctant to invest their money abroad given the currency risk. Docile shareholders have not pressured banks to increase returns by reining in low-margin lending.
A single currency changes some of these things. Pressures on banks will increase. In the short term, at least, some of their businesses will simply disappear: in currency trading between euro members, for example, in government-bond trading and in corporate banking. McKinsey, a consultancy, reckons that together these businesses account for 40-80% of European banks revenues.
For their part depositors can put their money in any bank they like, wherever in Europe it might be. That might erode banks traditional retail funding bases. Funding in wholesale markets will be more expensive. More competition in Europe has already led to a number of big mergers: ING of the Netherlands has taken over Belgiums BBL, for example. A single currency will mean more consolidation.
Might banks respond to greater competition for their customers by cutting their margins still further? There are three reasons to think they will not:
With the arrival of the euro, banks which lend too cheaply will find it hard to raise money from investors. This is already happening; but a single currency will encourage it.
Banks capital-to-asset ratios have been put under pressure by, among other things, losses in trading and in emerging marketsin Europe as much as anywhere. To increase these ratios, banks will have to start shedding assets or increasing capital. In America, corporate-bond markets did not really take off until the Latin American debt crisis of the early 1980s put severe pressure on banks capital ratios.
Anecdotal evidence suggests that banks have already started to tighten their lending criteria; the euro may encourage this process.
However, many of the pressures on banks will take time to develop. Depositors generally plonk their money in a bank whose name they are familar with; banks lend to those they know: local knowledge is important, especially when lending to smaller companies. It will take a long time to wean Europes companies away from banks and on to bonds.
In the case of equities, other factors will influence supply. It will be driven partly by a wave of initial public offerings, as companies merge and expand to reap economies of scale; and by continuing privatisation of state-owned firms, driven in part by the restrictions on government borrowing that membership of the euro entails. McKinsey expects privatisations worth some $125 billion in the next five years.
European investors will be able to choose between lots of different shares in lots of different countries. That may eventually affect the way European companies treat their shareholders, forcing them to show investors that they will earn a decent return on that equity. Moodys, a rating agency, predicts a spread of Anglo-Saxon-style shareholder pressure.
Well, perhaps. Europe still has a long way to go in this regard, and investor protection in many countries is still weak. Sooner or later, governments may notice that the countries where it is weakest, such as France and Italy, have some of the smallest equity markets.
As the European Commission accepts, many more changes are required before Europe really has a single, homogenous capital market. Tax, regulation, supervision, listing requirements, accounting, trading rules: all require far greater harmonisation if this is to be created. And, though monetary union is likely to speed things up a bit, progress on all of these things is likely to be grindingly slow. It will take longer than most suppose for the old world to catch up with the new.